This is a guest post from Bo Lu, CEO of FutureAdvisor, a fee-only registered investment advisor.
Find out now: How does my 401(k) work?
What is rebalancing?
Rebalancing is a portfolio management technique that builds upon two basic tenets of investing, diversification and ‘staying the course,’ by maintaining a constant proportion of assets from year-to-year. In doing so, your portfolio will be better guarded against market swings, and you can see healthy savings in the long run.
To demonstrate the power of rebalancing, we’ve run an analysis highlighting the savings that a rebalanced portfolio would have experienced through the two most recent major financial bubbles. We start by assuming a simple initial $100,000 portfolio with a typical 70-30 percent stock/bond split. The graph below tracks the progress of the investments with and without annual rebalancing through the 1990s’ dot-com bubble and the 2000s’ real-estate burst.
It shows that rebalancing your portfolio annually would have helped you weather the storms of the economic downturns and left you with a healthy profit at the end.
Try it for yourself!
Data: Ibbotson Stocks, Bonds, Bills, and Inflation Classic Yearbook, Morningstar Inc., 2010
The basic mechanics: it’s just math
A portfolio is a mixture of different types of assets in different proportions. These proportions are usually determined based on the investor’s tolerance for risk, age, and other factors. Because they are different, these assets will grow at differing rates over a year; for example, your bonds may grow at 2% in a year when your stocks sky-rocket and grow by 20%. This imbalanced growth means that your asset mix at the end of the year is different from the proportions that your portfolio contained originally. Rebalancing your portfolio in this case would involve selling some of your disproportionately highly-weighted stocks and allocating that money to bonds, in order to restore the original targeted ratio between the two.
Past performance does not indicate future results
So, how does rebalancing apply basic investment principles to earn people money? Rebalancing allows your portfolio to retain proper diversification every year. Maintaining a mix of different types of assets minimizes risk as different markets rise and fall. As time goes on, your portfolio assets naturally change. But if your initial diversification goals haven’t changed, your portfolio’s balance shouldn’t change either. You shouldn’t be swayed easily by past results; the market tends to even itself out over time.
On the chart, you may have noticed that, around the time of the dot-com bubble (1999), your rebalanced portfolio would have been significantly outperformed by the hands-off approach. This is because, as the bubble loomed, stocks grew at much greater rates than bonds did. Rebalancing would have required selling some high-performing stocks for bonds that would not have performed as well the next year. However, as you can also see from the chart, as the markets stabilized after that year. Rebalancing was a wise long-term choice because your portfolio recovered along with the rest of the market.
What can you do about it?
A financial advisor can be integral in this process by consulting with you, determining an optimal strategy, and compiling a mix of assets built for success based on your personal situation. Then, the advisor will manage your portfolio, periodically making trades to restore the target balance. While these tasks can be done by a human, digital financial management firms such as FutureAdvisor Premium provide similar diversification recommendations and automated rebalancing, along with other wealth management services.
If you’re looking to significantly build the value of your portfolio in a relatively straight-forward way, consider diversifying your portfolio and then tuning it up yearly by rebalancing. Take advantage of the available financial advice, based on math and proven historical results, and use it to help you withstand difficult financial times. The potential savings are hard to ignore.
Photo Credit: jwellsrobinsonpc